The classic prescription for economically efficient
pricing---set price at marginal cost---is not relevant for
technologies that exhibit the kinds of increasing returns to scale,
large fixed costs, or economies of scope found in the
telecommunications and information industries. The appropriate
guiding principle in these contexts should be that the marginal
willingness to pay should be equal to marginal cost. This condition
for efficiency can be approximated using differential pricing, and
will in fact, be a natural outcome of profit-seeking behavior.

Recent advances in information technology have rekindled interest in
the efficiency of markets as resource allocation mechanisms.
Traditional economic analysis typically examines situations where the
prevalent technology involves no economies of scope and constant or
decreasing returns to scale. In such industries the conventional
wisdom "set prices at marginal cost" is both economically viable and
the likely outcome of competitive forces.

However, many important industries involve technologies that exhibit
increasing returns to scale, large fixed and sunk costs, and
significant economies of scope. Two important examples of such
industries are telecommunications services and information
services. In each of these cases the relevant technologies involve
high fixed costs, significant joint costs and low, or even zero,
marginal costs [1]. Setting prices equal to marginal cost
will generally not recoup sufficient revenue to cover the fixed costs
and the standard economic recommendation of "price at marginal cost"
is not economically viable. Some other mechanism for achieving
efficient allocation of resources must be found.

This paper reviews some key points about how prices should be set in
environments of this sort. I examine this question both from a
positive and normative point of view. On the normative side I examine
characteristics of efficient pricing; on the positive side, I examine
the likely outcome of profit-seeking behavior in these environments.

The outcome of this investigation is that (i) efficient pricing in
such environments will typically involve prices that differ across
consumers and type of service; (ii) producers will want to engage in
product and service differentiation in order for this differential
pricing to be feasible; and, (iii) differential pricing will arise
naturally as a result of profit seeking by firms. It follows that
differential pricing can generally be expected to contribute to
economic efficiency [2].

Economists say that an economic situation is (Pareto) efficient
if there is no way to make one consumer better off without making some
other consumer worse off. For many cases of interest, Pareto
efficient outcomes can be thought of as those that maximize the sum of
economic benefits minus costs [3].

Standard economic analysis can be used to derive the following
principle.

Necessary condition for Pareto efficiency. A
necessary condition for Pareto efficiency is that that the
marginal willingness to pay must equal marginal cost.

In order to correctly understand the concept of efficiency, it is
important to be clear about each of the italicized terms in this
condition. First "necessary" means that the condition must hold if
the situation is economically efficient, but the condition may
hold in circumstances without implying that the situation is
efficient. For example, forcing a firm to charge a price equal to
marginal cost can easily fail to be efficient if such pricing fails to
cover total costs; we present several examples of this phenomenon
below.

Second, "marginal willingness to pay" refers to the willingness to
pay for an incremental unit of the good and "marginal cost" refers
to the cost of providing an incremental unit of the good. Once these
terms are understood, it is not hard to see why efficiency requires
that marginal willingness to pay must equal marginal cost. If any
consumer valued an additional unit of the good at more than it
cost to produce that unit, then it is possible to make that consumer
better off by producing an extra unit of the good and selling it to
that consumer at some (consumer-specific) price greater than or equal
to the cost of producing the incremental unit. Such a transaction
would make the consumer in question better off without making anyone
else worse off, showing that the original configuration was not
Pareto efficient.

If consumers pay a constant price for each unit of the good that they
consume, then it follows that that price must be equal to marginal
cost. On the other hand, there is nothing inherent in these
principles that says the price must be constant---nonlinear prices are
very common in the real world. Efficient pricing only requires that
the marginal unit of the good must be sold at marginal
cost---not that every unit of the good be sold at marginal
cost.

To see this, consider the simple example of a technology of a
single-product firm that exhibits constant marginal cost and positive
fixed cost. In this case setting price equal to marginal cost is
not economically viable since such a price would not recover fixed
costs. However, nonlinear pricing may well be viable: for example
charging users a positive access fee (to recover the fixed costs) and
a constant marginal cost of usage (to recover the variable costs) can
easily be efficient in this context.

It should be pointed out that this particular example is very simple.
In particular, we have assumed that the firm produces only a single
product. If the firm in question produces several products, a more
complex analysis is called for. But the central point remains valid:
marginal cost pricing does not imply efficiency since there is no
guarantee that revenues will be sufficient to cover total costs.

Let us consider this example in more detail. Suppose that there are
two classes of consumers for a particular telecommunications service:
those with a high willingness to pay and those with a low willingness
to pay. The telecommunication service in question exhibits a
technology with high fixed costs (of, e.g., building and maintaining a
network), but low marginal costs (of, e.g., providing additional
service to existing customers).

In this case, the two-part tariff described above is a very
natural pricing scheme. Consumers are charged an attachment fee to
connect to the network; the revenue from these attachment fees are
used to cover the fixed costs of providing the service, while the
price of usage itself is pegged to incremental cost. The attachment
fee is set so that the firm's total cost is recovered and the
necessary condition for Pareto efficiency is satisfied.

It should be emphasized that this is not the only form of efficient
pricing in this framework; one could use other forms of nonlinear
pricing. The basic requirement that efficiency imposes is the one
alluded to above: the marginal willingness to pay must equal marginal
cost.

The above analysis, simple though it is, yields an important insight:
The characteristics of consumer demand are an integral part of
efficiency judgments. Whether or not a particular policy is efficient
cannot be based on cost considerations alone.

Pricing at marginal cost may or may not be efficient: it depends on
how the consumers' total willingness-to-pay relates to the total cost
of providing the good. To see this, consider the following simple
example. Consumer A is willing to pay $10 for a single unit of a
good, and consumer B is willing to pay $5. There is a zero marginal
cost of producing multiple units of the good, but there is a fixed
cost of $10. In this case, total benefits are $15 and total costs
are $10, so it is socially worthwhile to produce the good.

There are a variety of ways to recover the fixed cost: each consumer
could pay $5, consumer A could pay $10 and consumer B could pay
nothing, etc. The only requirement is that consumer A pays no more
than $10 and that consumer B pays no more than $5---otherwise they
would not be willing to purchase the good.

On the other hand, suppose that the fixed cost of producing the good
were $20. In this case, the total benefits from producing the good
are $15 and the total costs are $20. There is no way to
allocate the good (and the cost of producing it) to the two consumers
in a way that makes them both better off than they would be if the
good were not produced at all.

This is simply another way of illustrating the point made earlier:
efficiency requires that the marginal user face marginal cost, but
making all users face a constant price equal to marginal cost
can easily fail to be efficient.

The requirement that the marginal user pay marginal cost is a strong
one, especially in cases where the marginal cost of usage is close to
zero. One prominent example is information goods: the incremental
cost of stamping out another CD or printing another book is on the
order of a dollar. The incremental cost of downloading a purely
digital good, such as a computer program, is on the order of a few
cents at most. In these cases, efficient pricing of such goods would
require that users with a very low value for such goods pay a very low
price.

One might think that it is rare to observe information goods selling
for virtually nothing, but on reflection, this is not so uncommon.
Many information goods are supported by advertising and sell for
prices close to their marginal cost of production and delivery:
newspapers and magazines are obvious examples. Books sell for a high
price as hardbacks, and much lower prices when reissued as paperbacks.
Remaindered books sell for very little. And all sorts of printed
material---books, magazines, newspapers, etc.---are available in
libraries at effectively zero cost to the users. In addition, there
are thousands of shareware computer programs that sell for extremely
low prices---on the order of a few dollars.

Similarly, there are telecommunications policies that involve selling
services at very low prices. Lifeline rates are a good example. With
such plans, needy consumers (who are likely to have a low willingness
to pay) can receive telephone services for only a few dollars per
month.

Still, a few dollars is still more than a marginal cost of zero. One
may well ask how significant a violation of efficiency is involved
when marginal users facing a price that is slightly above marginal cost.
This question can be answered using the tool of consumer
surplus. Consider Figure 1, which illustrates a demand curve for a
good; we assume a marginal cost of production of zero. We imagine a
nonlinear pricing scheme which collects different fees from different
users; we've also illustrated the revenue collected from the consumers
in the diagram.

Efficient pricing requires that the marginal user face a marginal
price of zero; in the case illustrated, the marginal price is greater
than zero, so some users who have positive value for the good choose
not to purchase it at that (marginal) price. The aggregate consumers'
surplus is less than the maximum possible amount. But how much is
this loss? The value of the lost output is simply the area indicated
by the black triangle in the diagram: this area the total amount
the excluded consumers would have been willing to pay for the
good. This triangle represents the value of the transactions that did
not take place because the marginal price exceeds marginal cost.
However, note that if the marginal price is quite low, the loss from
not setting it precisely at zero is also very low. It is at most the
marginal price times the number of people who value the good at less
than that price. If the marginal price is quite small, the losses
from the fact that it exceeds marginal cost will also generally be
quite small.

We have seen that efficient pricing requires that the marginal
willingness-to-pay equals marginal cost, but that differential and/or
nonlinear pricing will typically be required for full efficiency when
the underlying technologies have significant fixed costs. We now
consider conditions under which profit-seeking firms will have an
incentive to price in efficient ways.

The first observation is a simple one: if marginal willingness to pay
exceeds marginal cost, there is an obvious incentive for a
profit-seeking firm to supply the good at some price between the
willingness-to-pay and the marginal cost of provision, thereby
increasing its profits. In the extreme case described above, where
the marginal cost of provision is zero, a profit-maximizing producer
would want to supply the good to everyone who had a positive
willingness to pay for the good, no matter how low!

Recall the definition of Pareto efficiency: this is a situation where
there is no way to make one person better off without making someone
else worse off. If someone values an additional unit of a good at
more than its marginal cost, this is inefficient. But this is also a
profit opportunity: a producer would find it profitable to provide an
incremental unit of the good to anyone who valued it at more than its
marginal cost. Thus, the profit motive tends to correct an
inefficiency of this sort.

What is it that stands in the way of such mutual Pareto improvements?
The problem is that the firm would not want to offer the good at a low
price to marginal customers when such an offering would have an
adverse effect on the firm's ability to sell to inframarginal
customers. That is, selling an incremental unit at more than marginal
cost increases profits in the first instance. It is is only when such a
sale reduces profits made on the units sold to other
consumers, that the firm may wish to forgo this profit opportunity.

To understand this point more deeply let us review the basic
microeconomics of price differentiation. Economists generally follow
the taxonomy of Pigou, who used the term price discrimination
to describe what we have been referring to as differential pricing.
Pigou described three different forms of price differentiation [4]:

First-degree price discrimination means that
the producer sells different units of output for different prices
and these prices may differ from person to person. This is
sometimes known as the case of perfect price discrimination.

Second-degree price discrimination means
that the producer sells different units of output for different
prices, but every individual who buys the same amount of the good
pays the same price. Thus prices depend on the amount of the good
purchased, but not on who does the purchasing. A common example of
this sort of pricing is volume discounts.

Third-degree price discrimination occurs
when the producer sells output to different people for different
prices, but every unit of output sold to a given person sells for
the same price. This is the most common form of price
discrimination, and examples include senior citizens' discounts,
student discounts, and so on.

Under first-degree price discrimination, or perfect price
discrimination, each unit of the good is sold to the individual who
values it most highly, at the maximum price that this individual is
willing to pay for it. If the producer has sufficient information to
determine the maximum willingness to pay for each consumer, it will be
able to extract the entire consumer surplus from the market.

Since the producer gets all the surplus in the market, it wants to
make sure that the surplus is as large as possible. Put another way,
the producer's goal is to maximize its profits (producer's surplus)
subject to the constraint that the consumers are just willing to
purchase the amount of the good or service it provides. This means
that the outcome will be Pareto efficient, since there will be
no way to make both the consumers and the producer better off: the
producer's profit can't be increased, since it is already the maximal
possible profit, and the consumers' surplus can't be increased without
reducing the profit of the producer.

This, in turn, implies that a perfectly price-discriminating producer
must produce at an output level where marginal willingness to pay
equals marginal cost: if the marginal willingness to pay were greater
than marginal cost, that would mean that there is someone who is
willing to pay more than it costs to produce an extra unit of output.
So why not produce that extra unit and sell it to that person at his
or her reservation price, and thus increase profits?

Just as in the case of a competitive market, the sum of producer's and
consumers' surpluses is maximized. However, in the case of perfect
price discrimination the producer ends up getting all the
surplus generated in the market.

Perfect price discrimination is an idealized concept; in order to
engage in perfect price discrimination a producer must know the
willingnesses-to-pay of its customers and be able to prevent resale.
Both of these requirements are difficult to realize in practice and
perfect price discrimination is not commonly observed in the real
world. However, a close variant---second-degree price
discrimination---is quite common.

It is important to understand the sense in which the producer who
engages in first-degree price discrimination "extracts all the
consumers' surplus" in the market. This is to be interpreted as the
surplus above and beyond the surplus that would accrue to the
consumer if he or she had not participated in the market for this
particular good or service. Even though consumers acquires no
surplus in the particular market in question, they still be
substantially better off that if they had not purchased the good at all.

To illustrate this point, let suppose that there are two consumers,
A and B who are currently using a pay phone at the local grocery
store. They each value this pay-phone service at $10 per month, and
it costs them $8 per month to use it. Hence, the consumers each achieve
a net surplus of $2 each.

Consumer A would be willing to pay up to $5 additional dollars per
month for in-home service, while consumer B would be willing to pay
up to $2 additional dollars per month for in-home service. Thus
A's total value for in-home service is $15 (=10+5) and B's
total value is $12 (=10+2). Suppose that it would cost $21 per
month altogether to provide both of these consumers with
in-home service.

If the telecommunications provider charged a price of $12 to each
consumer for in-home service, consumer B would get zero surplus by
purchasing in-house service, but $2 of surplus from using the pay
phone. Hence he would continue to use the pay phone. Consumer A
would get $3 = 15 - 12 of surplus from in-home service and $2 from
the pay phone. Hence consumer A would choose in-home service.
Unfortunatly, the $12 of revenue from this consumer would not be
sufficient to cover the total costs of $21.

If the provider charged $10 per month, both consumers would purchase
in-home service, but again the revenue raised would not succeed in
covering the cost of providing that service.

However, if the provider charged user A $13 and user B $10, it
would raise a revenue of $23, which would more than cover its costs
of $21. Each consumer would get a surplus of $2, the difference
between the total value of the service purchased, and how much he or
she has to pay for it. Since the consumers would achieve the same
surplus from in-home service as from the pay phone, they would be
willing to purchase the in-home service at these prices.

In this case, the producer cannot extract the full surplus of
consuming the service since there is a competititive alternative
yielding a net surplus of $2. As always the pricing flexibility of
the producer is limited by the competitive alternatives available. A
perfectly price discriminating producer can only extract the surplus
above that surplus provided by alternative suppliers. The
surplus achievable via the competitive alternative puts a floor on the
surplus the consumer ends up with.

Second-degree price discrimination is also known as the case of
nonlinear pricing, since it means that the price per unit of
output is not constant but depends on how much one purchases. This
form of price discrimination is commonly used by public utilities; for
example, the price per unit of electricity often depends on how much
is bought and the price of long-distance telephone service is lowest
for the largest buyers. In other industries bulk discounts for large
purchases are frequently available.

We saw that in the case of perfect price discrimination, the producer
has to know the demand curves of the consumers; that is, the
producer has to know the exact willingness to pay of each person.
Even if the producer knows something about the statistical
distribution of willingness to pay---for example, that college
students are willing to pay less than yuppies for movie tickets---it
might be hard to tell a yuppie from a college student when they are
standing in line at the ticket booth.

Similarly, an airline ticket agent may know that business travelers
are willing to pay more than tourists for their airplane tickets, but
it is often difficult to tell whether a particular person is a
business traveler or a tourist.

One way to get around this problem is to offer two different
price-quantity packages in the market. One package will be targeted
toward the high-demand person, the other package toward the
low-demand person. It can often happen that the producer can
construct price-quantity packages that will induce the consumers to
choose the package meant for them; in economics jargon, the producer
constructs price-quantity packages that give the consumers an
incentive to self-select.

Under certain assumptions about the form of consumer demand, it can be
show that the optimal thing for the producer to do is to offer the
consumer with the highest demand an efficient amount of the
good---that is the amount of the good where the willingness to pay for
an incremental unit is equal to the incremental cost of providing that
unit. The consumer with the lower demand is offered an
inefficient amount of the good---he would be willing to pay more
than the incremental cost for an additional unit of the good. The
reason that the low-demand consumer is offered an inefficient amount
of the good is to avoid making a price-quanitity combination that is
too attractive to the consumer with high willingness to pay [5].

In practice, the producer often encourages this self-selection not by
adjusting the quantity of the good, as in this example, but
rather by adjusting the quality of the good. The earlier
allusion to airline pricing provides a nice example. U.S. airlines
normally offer two kinds of airline tickets. One kind has no
restrictions: business travelers find these unrestricted fares
attractive since their travel plans may change suddenly. The other
fare involves several restrictions: the traveler must stay over a
Saturday night, must buy the ticket 14 days in advance, and so on.
The presence of these restrictions makes the ticket less attractive to
business travelers---the travelers with high willingness to pay---but
the restrictions are still acceptable to tourists. By and large, each
type of traveler selects the fare class intended for him or her and
the airline makes substantially more surplus than if it had to sell
each ticket at a flat price.

We have seen that if a producer can identify users with
different willingesses-to-pay, and charge them accordingly, there may
be no efficiency loss at all: the producer would simply charge each
user his or her maximum willingess to pay. Users with high
willingnesses-to-pay would pay a high price; users with low
willingness-to-pay would pay a low price, but everyone who valued the
good at more than its marginal cost of production would be served.

If the producer cannot precisely identify the users, it may want to
adjust the characteristics of the good being sold so that users
self-select the product targeted for them. In this case, the
resulting outcome may be less efficient than it would be if perfect
price discrimination were possible. The efficiency cost is the value
of the transactions that consumer A would like to consume, but is
prevented from doing so by the producer since that would make too
attractive a package for consumer B.

In the case of the airline example, this efficiency loss is the extra
hassle of buying tickets 14 days in advance, staying over a Saturday
night, etc. These sort of restrictions are of little direct
benefit to the airline---their only purpose is to separate the low
willingess-to-pay consumers from the high willingess-to-pay consumers.

Still second-degree price discrimination may well be more efficient
than no price discrimation at all, since without such price
discrimination the markets with low demand may not get served at all.
Reducing the quality or quantity of the good offered to the market
with the low willingness to pay may make them somewhat worse off due
to the inconvenience cost. On the other hand, without such a device
to segment the market, the producer may not want to servce the
low-demand market.

The Saturday-night stay over is a small inconvenience for the tourist
traveller, but a large inconvenience for the business traveller. If
the airlines were not allowed to differentially price in this way,
airline tickes would almost certainly be significantly larger, airline
travel would be reduced, and welfare would likely be lower. This
point is explored in detail in Deneckere and McAfee [1996], who show that
price/quality discrimination of the sort described can easily make all
parties to the transaction better off than if price discrimination
were not possible.

In third-degree price discrimination, the producer is able to identify
different consumer groups who have different willingnesses to pay.
This is a very common form of price discrimination: senior citizen
discounts, student discounts, etc. are widely used. This form of
price differentiation is often used in telecommunications industries:
lifeline pricing, differential pricing for business and households,
etc.

Is third-degree price discrimination generally a good thing or a bad
thing? One way to answer this question is whether the presence of
third-degree price discrimination increases or decreases total
surplus. This question was first analyzed by Robinson [1933]; notable
subsequent contributions were made by Schmalensee [1981],
Varian [1985], and Schwartz [1990].

For simplicity we will assume that the good is provided at constant
marginal cost, and that there are only two groups of consumers
involved. We want to compare two scenarios: one where differential
pricing is allowed, the other where it is not.

If differential pricing is not allowed the firm is required to sell to
the two different groups at the same flat price p0. If
differential pricing is allowed, the firm may charge two different
prices to the two groups, p1 and p2. It can be shown that the
change in total welfare (consumer plus producer surplus, denoted by
DW, that results from moving from uniform pricing to
differentiated pricing is bounded by the following expression [6]:

(p0-c) [Dx1 + Dx2] >
DW
>
(p1-c)Dx1 + (p2-c)Dx2

In this expression, Dx1 denotes the change in the demand for the good in
market 1.

Some intuition for this expression may be found by examining
Figure 2, which depicts the impact of a price change for a single good. The
change in welfare from moving from p0 to p1 is given by the trapezoidal
area. It is easily seen that this is bounded by the two rectanges (p1-c)Dx1 and
(p2-c)Dx2. The complete analysis alluded to above shows that this same
bound holds if there are many goods.

Figure 2: Welfare bounds. The trapezoid is the true change
in consumer's surplus. It is bounded above and below by the two
rectangles.

This bound has the following implication: the left-hand side of
expression (1) shows that a necessary condition for efficiency to
increase when price differentiation is implemented is that total
output increases. If output remains constant or decreases when price
discrimination is allowed, total welfare must necessarily decline.

On the other hand, welfare may easily increase when price
differentiation is allowed, as long as output increases significantly.
The requirement is that the weighted change in output on the
right-hand side of expression (1) is positive.

We can see how this works in Figure 3. Here we have illustrated two
demand curves. Consumers in market 1 have a high willingness to pay,
and consumers in market 2 have a low willingness to pay. If only
uniform pricing is allowed, market 2 will not be served.
However, if differential pricing is allowed, the firm will find it
profitable to serve both markets.

Figure 3: Unserved markets. Without price
discrimination, small niche markets may not be served.

This is a good example to keep in mind. Small, niche markets will
generally not be well-served if the producer is required to charge a
uniform price. In cases of this sort, differential pricing can provide
very significant efficiency gains since it allows markets to be served
that would otherwise not be served at all. Hausman and MacKie-Mason [1988] examine this
point in some detail and describe some specific examples where it is
relevant.

Summing up our discussion of the welfare effects of price
discrimination, we see that:

Second-degree price discrimination generally provides
an efficient amount of the good to the largest consumers, but
smaller consumers may receive inefficiently low amounts.
Nevertheless, they will be better off than if they did not
participate in the market. If differential pricing is not allowed,
groups with small willingness to pay may not be served at all.

Third-degree price discrimination increases welfare
when it encourages a sufficiently large increase in output. If
output doesn't increase, total welfare will fall. As in the case of
second-degree price discrimination, third-degree price
discrimination is a good thing for niche markets that would not
otherwise be served under a uniform pricing policy.

The general impression that follows from this discussion is if price
differentiation allows more consumers to be served it will generally
increase welfare. Volume discounts, for example, can be expected to
generally enhance welfare. Market segmentation that allows
markets to be served that would otherwise be neglected is also a case
where overall welfare can be expected to be enhanced.

On the other hand, price differentiation that merely shuffles prices
paid by pre-existing customer groups and that does not result in an
increase in the number of customers served, or the amount that they
consume, will tend to reduce overall welfare. The key issue is
whether the output of goods and services is increased or decreased by
differential pricing.

We have examined the theory of differential pricing, but what about
the facts? The evidence shows that differential pricing is ubiquitous
in industries that exhibit large fixed or shared costs. This is true
for industries that are highly concentrated and industries
that are highly competitive.

Airlines The airline industry is highly
competitive in many ways, yet it is common to see differential
pricing practiced in a variety of forms. As we have seen airlines
offer different types of consumers different fares (senior citizen
discounts, major corporations, convention goers, etc.); they offer
different classes of service (first class, business class, tourist
class); they offer different sorts of restricted fares (advanced
purchase, Saturday night stayovers, etc.)

Telecommunications The long-distance
telecommunications market in the U.S. involves many different forms
of differential pricing. Firms give quantity discounts to both
large and small customers; charge business and individuals different
rates; and offer calling plans that offer discounted rates based on
individual characteristics and usage patterns.

Publishing A book which sells for $40 can be
produced at a marginal cost of $2. This gap between price and
marginal cost has led to a variety of forms of differential pricing.
Book clubs, hardcover and paperback editions, and remaindered books
are all examples of the ways that the product characteristics and
adjusted to support differential pricing.

Lighthouses This example is rather interesting
from a historial perspective. Economists have often used
lighthouses as an example of a good that would be best provided as a
public utility due to the difficulty of recovering costs. For our
purposes, their interesting feature is that the cost of servicing
incremental users is negligable. As Samuelson [1964] puts it
"... it costs society zero extra costs to let one extra
ship use the service; hence any ships discouraged from those waters
... will represent a social economic loss ... ." Coase [1974]
examined historial record and found that privately financed
lighthouses were provided in England for hundreds of years. Even
more remarkably, the pricing arrangement they used was quite
efficient: they charged on a sliding scale based on the number of
voyages a trip took per year. After 6-10 trips per year, the
incremental price for the services of the lighthouse was
zero, just as efficiency requires.

It is easy to construct examples where some consumers will not be
served unless differential pricing is permitted; we have alluded to
this in our discussion of "niche markets" earlier. Consider, for
example a case with two consumers one of whom would pay $20 for a
telecommunications service, and the other of whom would pay $5. For
simplicity, assume that the marginal cost of providing the service is
zero. If the firm supplying the service is required to sell at a
uniform rate to both consumers, it would clearly find it most
profitable to set a rate of $20.

If, however, the firm is able to price the product differently to both
classes of consumers, it would find it most profitable to sell to the
high-value user at a price of $20 and the low-value user at a price
of $5.

This is yet another example of how flat pricing may have
perverse consquences: forcing a producer to sell to everyone at the
same price may sound like a good idea. But it can easily end
up encouraging the producer to sell only to the high end of the
market. Differential pricing gives the producer an incentive to
supply the product to everyone who is willing to pay the incremental
cost of production.

An even more striking example can be constructed if we assume that
there is also a fixed cost of production of $25. In this case, there
is no uniform price at which the firm can recover its costs.
The only economically viable solution is for the firm to charge each
user according to his or her willingness to pay. If there are large
fixed costs, and low marginal costs, differential pricing may be
required for a producer to be economically viable.

It is sometimes argued that "essential services" should not be
differentially priced. The term "essential service" is rather
vague, but one might define it as a service that everyone would want
to have if they could afford to purchase it. For such services,
differences in willingness to pay arise primarily from differences in
income rather than tastes.

If this is the appropriate definition of "essential service" then
the case for differential pricing outlined above is even stronger.
Differential pricing implies that users with higher willingness-to-pay
end up paying higher prices than users with lower willngnesses-to-pay.
If differences in willingness-to-pay are primarily determined by
differences in income, then differential pricing is effectively
charging users with higher income more than those with lower income.

We have considered differential pricing in consumer goods. However,
the same principles apply to markets for intermediate goods. In
particular, technologies with large fixed costs, low marginal costs
and/or significant shared costs may easily require differential
pricing to be economically viable.

Consider, for example, the following simple numerical example. A
supplier offers a service that has fixed costs of $10 and marginal
costs of $1 per unit supplied. Two customers each want to purchase
one unit of the service, which they use as an intermediate good to
produce a final service which they sell to the consumers. Customer A
is willing to pay $12 for the service; customer B is willing to pay
$5. Consider the following scenarios.

Sell service at marginal cost. In this case
the producer sells the service at a price of $1 to each of the
customers, but would then fail to recover its fixed costs, which
is not economically viable.

Sell service at a flat price. In this case the
supplier would find it most profitable to set a price of $12 and sell
only to customer A. Customer B would not be able to purchase the
service event though it would be willing to cover marginal cost.

Differential pricing. If differential pricing
is feasible, the producer would set a price of $12 for customer A and
$5 for customer B. Each customer would be serviced and the supplier
would be able to cover its fixed costs.

Telecommunications services often involve large fixed costs, low
marginal costs, and significant shared costs. If such services are
required to be provided to a large number of diverse users, and costs
are to be covered without the use of externally provided subsidies, it
is very likely that differential pricing will be necessary.

To see this, let us consider the simple example used several times
before in this paper: a single-product firm with a large fixed cost
and a small, constant marginal cost. If a given population is to be
served, and flat pricing is the only option, then the price must be
set at the willingness to pay of the customer who has the lowest value
for the service. If the population has sufficient dispersion in
willingness to pay, the person with the lowest value may easily up
having a willingness to pay that is less than average cost of
production. But if the price is less than the average cost of
production, total costs cannot be recovered.

Put another way: the broader the population that must be served, the
lower the price that can be charged. But a sufficiently low price can
easily result in revenues that are inadequate to recover costs. The
only way out of this dilemma is to either provide subsidies for
customers with low ability to pay, or for the firm to engage in
differential pricing.

We have seen that differential pricing is a natural outcome of profit
seeking forces and may easily contribute to economic efficiency.
Forcing a policy of flat pricing in an industry where it is
inappropriate due to the nature of the technology may well have
perverse consequences. The key concern in examining the welfare
consequences of differential pricing is whether or not such pricing
increases or decreases total output.

Hal R. Varian, School of Information Management and Systems, 102 South Hall, University of California, Berkeley, CA 94720-4700.
Email: hal@sims.berkeley.edu
URL: http://sims.berkeley.edu/~hal.
Research support from NSF SBR-9320481 and Pacific Telephone is gratefully acknowledged.

1. By "joint costs" I mean the cost of those
factors of production that are used to produce more than one output.
In the remainder of the paper I generally consider the case of a
single-output firm since the points I wish to make are most simply
illustrated in that context.

2. Huber [1993], and no doubt several other
observers, have made the same point. The contribution of this
article is to lay out the economic theory that supports these conclusions.